7.4.3 Valuation of Spillover Costs and Benefits

In a world in which countries are linked by international trade, capital flows,
and technology transfers GHG abatement by one country has welfare effects on
others. In some cases these impacts, or spillovers, are positive and in others
negative. Spillovers are a broad concept that has been used in relation to a
number of different international inter-linkages between GHG emission reduction
policies and impacts on industrial competitiveness, reallocation of industry,
and a development and implementation of technologies. This section provides
a short introduction to these main categories of spillovers as an introduction
to Chapters 8 and 9 that include
a review of economy-wide and sectoral studies on spillovers.

GHG emission reduction policies potentially will have a major impact on industrial
competitiveness because sub-sectors that have relatively high GHG emission intensity
or have relatively high reduction costs potentially can lose in competitive-ness.

The basic theoretical framework is that of a full employment, open economy,
and no international capital mobility (Dixit and Norman, 1984). Within this
model an emissions constraint shifts the production possibility frontier inwards,
as long as the constraint requires some no regret measures to be
undertaken. The spillover impact of this shift depends on whether the emissions
reductions have a greater impact on the production of the export good, or on
the import competing good. If it is the former, abatements turn the terms of
trade in favour of the country that undertakes abatement and against the country
that does not. In these circumstances the non-abating country suffers some welfare
loss, while the abating country could be better or worse off, depending on the
size of the shift in terms of trade relative to costs of abatement. Conversely,
if emissions have a greater impact on the production of the import-competing
good, the terms of trade move in favour of the non-abating country, which should
have an increase in welfare. The analysis of industrial reallocation considered
in the previous section becomes further complicated when international capital
mobility is taken into account. Carbon constraints typically alter relative
rates of return against abating and in favour of non-abating countries. A flow
from the former to the latter is then likely, which shifts further inwards the
production possibility frontier in the abating country. At the same time, it
causes an outwards shift of the frontier in the non-abating country. Modelling
capital flows is notoriously difficult, however, and no theoretical results
can be obtained for the complex and empirically relevant cases. Hence the indisputable
need to use simulation models and to undertake primary empirical research. The
welfare impacts of changes in international capital flows are seldom reported.
Progress depends on the further development of techniques such as decomposition
analysis (Huff and Hertel, 1996)18
and multiple simulations in which some variables are held constant to isolate
their influence on the final outcome.

Seen from a more practical perspective the theoretical arguments about competitiveness
and international capital flows have at least two versions of what happens without
specific developing country targets: either domestic industry relocates abroad,
or the demand for domestic energy-intensive goods declines and the trade balance
deteriorates; or both occur.

Consider four factors that affect location or trade effects. First, do the
non-tradable sectors account for a substantial share of carbon emissions? Second,
are energy costs a small or large percentage of the total costs in key manufacturing
sectors? Third, is the burden of meeting an emission reduction target partially
borne by non-participating countries because of changes mediated through international
trade? For example, developed nations could demand fewer exports from non-participating
countries. This would shift the terms of trade against these countries, and
they would bear some of the costs of reducing GHGs. Fourth, how do resources
shift across sectors because of carbon policy? For instance, there could be
a shift from the energy-intensive sector to the domestic goods sector that is
non-energy intensive. The aggregate impact could be positive or negative depending
on the potential returns from the non-energy intensive sector.

First, consider the pollution havens hypothesis, in which firms
are tempted to relocate to or to build new plants in nations with lax environmental
standards (see Dean, 1992; Summers, 1992; Esty, 1994; Jaffe et al., 1994).
Palmer et al. (1995) point out that the following must be considered:

whether the cost of complying with environmental regulation is a small fraction
of total cost;

whether the differences between the developed nations environmental
regulations and those of most major trading partners are small or large; and

whether the firms of the developed nation build state-of-the art facilities
abroad regardless of the host nations environmental regulations.

The evidence to date on pollution havens is not strong, although this may change
in the future as international agreements on climate change come into force.

In the context of climate change, cost estimates must consider how carbon taxes
affect trade flows in the short and long runs. The leakage effect
reflects the extent to which cuts in domestic emissions are offset by shifts
in production and therefore increases in emissions abroad. The empirical question
is whether nations that are a net exporter in fossil fuel intensive products
(e.g., steel) gain under Annex I-only carbon policies. Other developing nations
might not gain because less capital will be available as the income in the developed
nations drops, and it becomes more costly to import from developed nations the
capital goods that promote growth (e.g., machinery and transportation equipment).
See Chapters 8 and 9 for any empirical
evidence on the magnitude of leakage.